Brooke’s note: I thought I knew everything I needed to know about diversification. All you do is buy shares of lots of companies under lots of names sprinkled across a number of industries, right? Not exactly, I concluded after a conversation with James Damschroder. It turns out that two stocks that appear very different superficially can be quite similar beneath the surface. The founder of Gravity Investments has created technology that is designed to take a CT scan of a portfolio to determine whether its components truly aren’t correlated. I wanted to write about the wonders of true diversification myself but I knew it was over my head. I asked Damschroder if he could contribute a column. Here it is.

In my role at Gravity Investments, I’m constantly running into advisors unsure of the best approach to use in managing their clients’ assets. As the creator of Gsphere, Gravity’s patented diversification optimization, measurement, and visualization platform, allow me to posit this oldie but goodie: A good portfolio is a diversified portfolio.

While last year’s financial crisis has left many investors wondering if diversification still has merit, my research suggests that it most definitely does. At least, diversification the way Gravity views it does. I’ve been championing diversification strategies for several years and nothing’s changed my view that true diversification can help improve a porfolio’s performance and an RIA’s reputation.

Modern Portfolio Theory (MPT) was a great intellectual achievement to be sure. To my way of thinking, the best thing about it was, and is, a recognition of diversification.

But make no mistake … Modern Portfolio Theory is risk-centric. It comes to its embrace of diversity through its analysis of volatility. Research shows that risk, or volatility, is a poor conduit for channeling diversification. So why not take a direct route to diversification and ignore volatility?

Diversification or volatility?

Why is measuring diversification better than measuring risk?

Because diversification is both more stable, i.e., predictable, and it relates better to real-life performance. The sad truth about modern portfolio management is that volatility and return relationship breaks down right when we need it.

We can illustrate that in the first chart accompanying this story. The orange line shows the average risk/return relationship across a full market cycle. The flat slope of the line clearly shows that there is simply no directional relationship between risk and return over time.

No directional relationship between risk and return over time

The implications of this dull relationship are profound, particularly to those advisors who consider themselves asset allocators more than money managers. Why? Because if the risk/return relationship fails, then the widespread use of an efficient frontier to map an investor to a portfolio has no relevance.

By extension, then, the so-called client ‘risk profile’ exercise is also of little relevance. It may even be a little dangerous. True, the process works to the degree that it helps understand the client and other criteria like tax rates, income, investment horizons, and income preferences, but that’s about it.

The glossy efficient frontier charts invariably show a positive association between risk and larger returns. If there is really no relationship, then the charts are wrong. And that means the ‘profiles’ are wrong as well. Dangerously wrong.

Big impact on returns

The second chart accompanying this story includes the diversification/return relationship along with the risk/return relationship. The red squares, which represent the diversification/return relationship in a bull market, show virtually no relationship.

In other words, diversification did not impact returns in a bull market one way or the other. The blue triangles represent the same diversification/return relationship in a bear market. The consistent positive slope shows that diversification stepped up when we needed it to protect capital.

The consistent positive slope shows that diversification stepped up when we needed it to protect capital.

Regression analysis of the 95 portfolios supporting these charts showed that a 100 basis point increase in diversification produced a 98 basis point improvement in return across a bear market. The impact on returns, in other words, is almost one to one.

The more predictable measure

Why is diversification more important than risk?

Overall, diversification is simply not impacted by the market to the nearly the same extent as risk. Like we said earlier, diversification is more stable than risk. What that means is portfolios models built on this more stable attribute will more closely conform to the actual future performance. This predictability is essential in setting and meeting client expectations.

The following chart shows how four broad portfolios’ risk and diversification values changed during the last four market crises—the Mortgage Meltdown of 2008, 9/11, the tech bubble collapse, and the 1997 Asian Currency/LTCM crisis. We compare the two months after the start of each crisis to the portfolios’ 10-year average.

We compare the two months after the start of each crisis to the portfolios ten-year average.

We compare the two months after the start of each crisis to the portfolios ten-year average.

It’s true enough that last year’s financial crisis has left many investors wondering which if, any, investment approach works in a tough market. While there are many strategies—active, passive, tactical, strategic, fundamental, or technical—I believe there’s only one approach that works over the long term: Diversification. Like they say, a good portfolio’s a diversified portfolio.

James Damschroder is founder & chief of financial engineering of Gravity Investments